Strategy: Central bank news overshadows all

19 Sep 2016

  • Better outlook for emerging markets, for now
  • US data continues to disappoint
  • Big week for US and Japanese monetary policy
  • Asset allocation: curve steepening a source of uncertainty

Economic data from emerging economies has looked up in the past few months. After the improvement in trade in China, recent data again surprised to the upside. Better trade data from China has also shone through in other countries’ numbers. After doing well from February through to August, emerging assets have wobbled recently, partly over concerns that the improvement could be just temporary. Markets may now pause, with the US Federal Reserve and the Bank of Japan both due to announce the results of policy meetings on Wednesday.


China is not alone in reporting better trade data. Our gauge of early reporting emerging market exporters, which includes Brazil, Chile, China, India, South Korea and Taiwan, has improved from deeply negative annual growth rates to only slightly negative rates (in US dollars). In local currency or in US dollars excluding China, exports from these countries grew slightly in August.

OECD Cyclical Leading Indicators have improved in China, South Korea, India, Brazil, Russia and Turkey, to name but a few countries, although the swing often just went from negative to neutral. A caveat from an investor point of view is that the equity market is a factor in most of these indicators. But the average emerging market manufacturing PMI also improved.

Stronger-than-expected Chinese data included industrial production growth and retail sales growth. Fixed asset investment growth did not slow further, although it remained weak in the manufacturing sector. Housing data were better balanced as sales outpaced construction activity. Credit growth accelerated somewhat in August.

While we now see the outlook for emerging markets as more neutral and no longer as negative, we have concerns about the sustainability and the strength of the improvement. The impact of massive monetary and fiscal stimulus in China may fade towards the end of the year; Brazilian households are still under tremendous pressure from falls in employment and real wages and a sharp slowdown in the credit cycle; leverage has reached risky levels in some countries, most notably in China; and the eurozone and the US economy are unlikely to boost demand strongly.


That household consumption would slow from its torrid pace in the second quarter was to be expected in the wake of modest gains in disposable income. Two months of falls in core retail sales primarily look like payback of earlier strength, but the sharp drop in car sales and stalling confidence bear watching.

Other risks include weak corporate profitability and its possible impact on business investment and employment. Companies can counter margin pressures by improving productivity, which can be difficult in the short term, by raising prices, for which we see little room, or by cutting costs at the expense of employment. Increasing leverage is also a risk, although for now, it is low due to high asset values and low interest rates.

The bar for improvement is low though. First-half GDP growth averaged just 1.0% QoQ annualised. The Atlanta Fed’s virtually real-time GDPNow index last week pointed to 3% growth in the third quarter, which looks feasible to us given the lower drag from inventories this quarter.


The outcome of the policy meeting on Tuesday and Wednesday looks set now: no rate rise. Of the other outcomes, a ‘dovish hike’ – where the Fed raises rates now, but plays down the possibility of further tightening this year – would be hard to explain for policymakers. Why raise rates now if there is not enough certainty to embark on a path of steady hikes? We believe growth or inflationary pressures do not justify such an outcome now.

The opposite – a ‘hawkish hike’ – would upset financial markets and the Fed should know this given the low probability of such a move that markets are currently discounting. But the individual policymakers’ forecasts for growth, inflation and interest rates should give markets fresh clues as to the direction of the Fed’s thinking. In June, most foresaw two or more rate rises this year. We expect the balance to shift towards a majority favouring just one hike.


The outcome of its deliberations on Tuesday and Wednesday looks more uncertain. What will the comprehensive reassessment which Governor Kuroda has announced bring? The BoJ might be pleased with the results of its policies so far – a tighter labour market and slow, but positive nominal wage growth; low, but positive core inflation and the economy weathering oil price shocks and the VAT hike last year.

It could just leave monetary policy unchanged, but that would risk strengthening the Japanese yen, driving down inflation further, and we believe the BoJ is not willing to go down that road.

A more likely outcome is cutting interest rates further into negative territory and engineering a steeper yield curve by directing the asset purchases towards the shorter end of the yield curve. This would somewhat mitigate the negative impact of a further rate cut on bank profitability.

After the volatility of the past two weeks, markets may now pause ahead of Wednesday’s central bank news. Obviously, these events could spark fresh volatility, although if the Fed and the BoJ stick to our scenarios, the market reaction should be limited.


Many curves have steepened sharply this month. The main drivers have been the ECB choosing not to change its asset purchase programme and not addressing the issue of bond scarcity as well as the view that the BoJ may try to engineer a steeper yield curve. A small change in central bankers’ attitude may have let markets adjust to reality to some extent. Positive economic surprises tend to be accompanied by steeper curves. But when the US surprise index peaked this summer, the US curve even flattened. With the surprise ratio coming down and the curve steepening, this relationship now looks more balanced. Anyway, steeper yield curves can affect the highly leveraged global economy and may lead to further re-pricing of financial assets. In other words, it is an added source of uncertainty for investors.

At this point, we think the outlook for the global economy is broadly neutral for equities. Growth should improve somewhat in the near term, although it will not be strong. Risks are ample and the sustainability of the improvement remains questionable. Low growth, low inflation and low productivity growth make for a challenging environment for company earnings. Yes, the drag from the pummelled energy sector should fade, leaving the trough behind us, but we do not foresee much higher profit levels. We prefer to stay cautious in our asset allocation.

WSU 190916

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